Inflationary Spiral

Definition

An inflationary spiral is a self-reinforcing cycle of rising prices and wages that can lead to high and persistent inflation in an economy. It occurs when increases in prices trigger demands for higher wages, which in turn lead to further price increases, creating a continuous upward spiral.

5 Must Know Facts For Your Next Test

1. An inflationary spiral is a key concept in understanding the limitations of indexing as a tool to combat persistent inflation.
2. The cycle of rising prices and wages can become difficult to break, as workers demand higher wages to maintain their purchasing power, leading to further price increases.
3. Indexing, such as adjusting wages or benefits to the rate of inflation, can contribute to an inflationary spiral by fueling the continuous upward pressure on prices and wages.
4. Governments and central banks often struggle to control an inflationary spiral, as traditional monetary and fiscal policy tools may be less effective in breaking the cycle.
5. Preventing an inflationary spiral typically requires a comprehensive policy approach, including measures to control wage growth, manage inflation expectations, and address the underlying causes of cost-push inflation.

Review Questions

• Explain how an inflationary spiral can develop and the challenges it poses for indexing as a policy tool.
  • An inflationary spiral begins when increases in prices trigger demands for higher wages, which then lead to further price increases. This self-reinforcing cycle can be difficult to break, as workers seek to maintain their purchasing power and employers pass on higher labor costs to consumers. Indexing, such as adjusting wages or benefits to the rate of inflation, can contribute to the inflationary spiral by fueling the continuous upward pressure on prices and wages. This poses a challenge for policymakers, as indexing may not be an effective tool to combat persistent inflation in the face of an inflationary spiral.
• Analyze the role of cost-push inflation in the development of an inflationary spiral and the implications for policy responses.
  • Cost-push inflation, where increases in the costs of production such as rising wages or input prices are passed on to consumers, can be a key driver of an inflationary spiral. As prices rise, workers demand higher wages to maintain their purchasing power, leading to further price increases. This cycle can become self-reinforcing, making it difficult for traditional monetary and fiscal policy tools to effectively control the inflation. Policymakers may need to address the underlying causes of cost-push inflation, such as managing wage growth and addressing supply-side constraints, in addition to using monetary policy to manage inflation expectations and break the inflationary spiral.
• Evaluate the potential long-term consequences of an uncontrolled inflationary spiral and the importance of a comprehensive policy approach to address it.
  • An uncontrolled inflationary spiral can have severe long-term consequences for an economy, including eroding the purchasing power of the currency, undermining consumer and business confidence, and potentially leading to economic stagnation or even hyperinflation. Addressing an inflationary spiral requires a comprehensive policy approach that goes beyond traditional monetary and fiscal tools. This may include measures to control wage growth, manage inflation expectations, address supply-side constraints, and tackle the underlying causes of cost-push inflation. Failure to implement a well-coordinated and effective policy response can result in the inflationary spiral becoming entrenched, leading to prolonged economic instability and significant hardship for households and businesses.

Related terms

Inflation: A sustained increase in the general price level of goods and services in an economy over time, reducing the purchasing power of currency.

Wage-Price Spiral: A situation where rising wages lead to rising prices, which then lead to demands for further wage increases, creating a self-reinforcing cycle of inflation.

Cost-Push Inflation: Inflation caused by increases in the costs of production, such as rising wages or input prices, which are then passed on to consumers in the form of higher prices.